Market headwinds raise stakes for Abe's Japan revival plan

Japan's Prime Minister Shinzo Abe gestures as he delivers a speech at a seminar in Tokyo June 5, 2013.

Reuters/Toru Hanai

TOKYO (Reuters) - This is not how Japan's Prime Minister Shinzo Abe probably imagined reaching a key milestone in his economic revival plan.

Pro-growth measures meant to complement hefty doses of budget and monetary stimulus met with a cool reception and their formal approval on Friday coincided with turbulence in financial markets hit by sharp reversals in global capital flows.

A sense of disappointment that steps unveiled over the past several weeks left out measures such as corporate tax cuts or labor market liberalization was so apparent that it made Abe promise more after July 21 upper house elections.

"The growth strategy decided today will be the starting point," Abe said in a video message on his office's Youtube channel.

"I will ensure political stability and in the autumn I will launch the second round of the growth strategy."

The challenge for Abe and his hand-picked central bank chief Haruhiko Kuroda will be how to sustain business and consumer confidence through the rough market patch until new policies take shape and measures adopted so far bear fruit.

Both have tried to soothe nerves with assurances that the economy was improving.

Economists agree that the economy should have enough momentum to cope with market turmoil and say there is not a lot more policymakers can do besides doing what they have already promised.

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"They have said what they want to do. Now it is a matter of execution," said Robert Feldman, chief economist at Morgan Stanley MUFG Securities in Tokyo.

The cabinet's rubber-stamping of the growth strategy, the so-called third arrow of Abe's economic remedy to two decades of stagnation, comes amid signs that the economy is picking up pace. Growth in the first quarter accelerated to an annualized rate of 4.1 percent, outpacing U.S. growth, and there is evidence that exports and output are also improving.

Much of that has been driven by improved global demand as well as relief for exporters from a weaker yen, as well as a boost to consumer and business confidence produced by the Bank of Japan's pledge to do whatever it takes to beat deflation, starting with doubling its monetary base in less than two years.

However, the yen clawed back some of its losses to trade at its highest levels in 10 weeks on Thursday, while stocks extended their recent slide to more than 20 percent since hitting a 5-1/2 peak hit on May 23.

REVERSAL

Such a reversal, driven mainly by shifting expectations about the scope of U.S. monetary stimulus, threatens to undermine that "feel good" effect from the bull market and softer currency.

Yet economists and commentators say as long as Abe stays focused on the economy, keeps ticking boxes on his "to do list" and makes good on his promise of a second batch of pro-growth reforms, there are reasons to be optimistic.

Economists at Nomura Securities estimate that just measures proposed so far - including special economic zones, power sector reform and incentives for private sector investment - if implemented would add 0.5 percentage points to economic growth every year until the end of this decade.

Analysts warn, though, it will not be smooth sailing.

In the first months of Abe's term all stars seemed aligned in his favor: rallying stocks and the retreating yen were boosting business morale and his push for a radical overhaul of central bank policies was winning plaudits at home and abroad.

However, things got more complicated with financial markets facing global headwinds, an upper house election that is Abe's to lose and some tough policy choices ahead.

For example, a cut in corporate tax rates advocated by business lobbies and one of Abe's advisers does not have the support of the powerful finance ministry.

Its chief Taro Aso on Friday questioned the wisdom of such cuts when the majority of Japanese companies were taking advantage of loss write-offs to effectively avoid paying such taxes

"Seventy-five percent (of corporations) are not paying," Aso told reporters. "So cutting corporate tax won't be effective for all those who are not paying."

In months after the elections the government will also have to decide whether to raise the sales tax to fund swelling social security costs and present a credible plan to meet its fiscal targets and rein in ballooning public debt, which is already exceeds two years' worth of the nation's economic output.

Opinion surveys show Abe's party is on course to win the upper house election by a big margin and gain full control of both chambers of parliament and some analysts say it is only natural for the government to play it safe until then.

"The Abe administration will probably start discussing controversial issues such as a corporate tax cut and labor market reform if his ruling party secures a stable government," said Junichi Makino, chief economist at SMBC Nikko Securities.